Reversal of fortune

Beware of Chinese bus-advertising firms backing into shell companies

NUMEROUS threats to the integrity of American public stockmarkets have emerged over the past year, including last May's “flash crash” and—if you believe its critics—NASDAQ's proposal to merge with the New York Stock Exchange. Now another menace is flashing on regulators' radar screens: the “reverse merger”, in which a private company goes public by combining with a listed shell company rather than via an initial public offering (IPO).

The practice, also known as “back-door registration”, is not new. It has long been used by small firms looking for a cheaper, easier route to public ownership. There are no underwriting fees, for instance. Unfortunately, it also risks allowing dodgy outfits to access public markets, and thus lure investors, because it enables them to avoid some of the disclosure—and the vetting by regulators, investors and underwriters—to which firms doing IPOs are subject.

The Chinese firms that account for a quarter of the more than 600 back-door registrations since January 2007 are a particular worry. This week Luis Aguilar, one of the five members of the Securities and Exchange Commission (SEC), suggested that a growing number of these have “significant accounting deficiencies” or are “vessels of outright fraud”.

At least one back-door registrant has admitted to inventing manufacturing contracts. Another stands accused of staging fake production of biodiesel when investors visited its plant. Several have had to restate earnings.

The focus of most attention, however, is China MediaExpress (CME), an advertising company that reverse-merged its way onto NASDAQ in 2009. Its auditor, Deloitte, resigned last month, citing lost confidence in the firm's financial reporting. This forced CME to reveal that Deloitte had had concerns on many fronts: the authenticity of bank statements, the validity of advertising agents and customers, undisclosed loans and double-counting of the buses on which the firm was supposed to run ads. One of CME's big shareholders is Starr International, run by AIG's former boss, Hank Greenberg. It has sued CME and Deloitte to recover its $13.5m investment.

Eager to stamp out any shenanigans, the SEC has set up a group to investigate fraud in foreign companies with American listings. But scarred investors should not hold their breath. The firms they backed may be registered in America but many of the documents relating to alleged misconduct, and the people behind them, are beyond the reach of authorities.

Some of their beancounters are out of reach, too. A recent report by America's Public Company Accounting Oversight Board (PCAOB) found that some American audit firms had signed off on the accounts of reverse-merged firms even though their opinion was based largely on work done by unrelated Chinese auditors, in breach of PCAOB guidelines. American regulators are blocked from inspecting audit firms in China. James Doty, the PCAOB's chairman, has called this “a gaping hole in investor protection”.

Legitimate operators—yes, they exist—complain that all Chinese “small-cap” shares are being tarred with the same brush. Some are contemplating going private. As they weigh their options, pressure will grow on regulators to scrap the reverse-merger structure. Exchanges that list reverse mergers, such as NASDAQ and NYSE Amex, have delisted or halted trading in at least a dozen stocks (some of which still trade in over-the-counter markets). NASDAQ has tightened listing procedures and started using investigative firms to scout applicants' domestic operations. By one estimate the combined market value of reverse-merged firms peaked at $50 billion. It is unlikely to be surpassed.